We’ve heard quite a bit about the new ‘two-strikes’ rule on executive pay in the media since an amendment to the Corporations Act, to toughen executive remuneration conditions, was passed in July. This amendment was the outcome of a Productivity Commission inquiry into executive remuneration released in January this year.
While more accountability to shareholders is a positive move I hope that shareholders exercising their votes to force changes in the level and structure of executive pay are aware of the recent research into the effectiveness of bonuses on performance, which may run counter to their intuition. Indeed, large performance bonuses are not always effective incentives.
First, here’s how the Senate’s explanatory memorandum describes the amendment:
This reform strengthens the non-binding vote and maintains the fundamental principle underlying Australia’s corporate governance framework that directors are responsible for, and accountable to, shareholders on all aspects of the management of the company, including amount and composition of executive remuneration.
That seems fair enough, but let’s take a closer look at how shareholder accountability will play out in practice:
Where a company’s remuneration report receives a `no’ vote of 25 per cent or more, the company’s subsequent remuneration report must explain the board’s proposed action in response or, if the board does not propose any action, the board’s reasons for inaction [Schedule 1, Item 19, paragraph300A(1)(g)]; and
Where the company’s subsequent remuneration report receives a `no’ vote of 25 per cent or more, a resolution must be put (known as the `spill resolution’) to shareholders at the same AGM. Notice of the spill resolution must be contained in the meeting papers for the AGM to ensure that notice has been given in the event that the second strike is triggered.
The notice must explain the circumstances in which the resolution will apply. [Schedule 1, Item 9, subsection 249L(2)]
If the spill resolution passes with 50 per cent or more of the eligible votes cast, another meeting of the company’s shareholders (known as the `spill meeting’) must be held within 90 days [Schedule 1, Item 13, section 250V]. A company will still need to provide the minimum notice period for holding a meeting, as required by the Corporations Act. A company will also need to comply with any minimum notice period set out in its constitution for the nomination of candidates for the board. This will ensure that shareholder nominated candidates can seek endorsement at the spill meeting [Schedule 1, Item 13, section 250W].
The separation of the `second strike’ and the `spill resolution’ is intended to ensure that shareholders are not discouraged from voting against the remuneration report, because they fear removal of certain board members. It ensures that shareholders are free to express their concerns on the remuneration report, and is intended to provide a clearer signal of shareholders’ views on the remuneration report.
In sum, the board has two chances to get shareholders on board with their remuneration structure or risk being voted out at the spill resolution.
One interesting feature of the amendment is that hedging of incentive payments for key management personnel will be prohibited. This improves on the 2007 amendment to the Corporations Act that required disclosure of company policy on hedging and enforcement mechanisms. There are a few other tweaks, including regulations around the appointment of remuneration consultants, voting on remunerations by key management personnel who themselves are subject to the report, and more.
Tightening legislative restrictions of executive remuneration is part of a global movement – shareholders ‘Occupying the Boardroom’ you might call it (as discussed here):
The tougher Australian laws parallel similar moves in the Netherlands, Norway, Sweden and the United Kingdom which have responded to public outrage about executive pay levels.
The US has also introduced similar legislation effective from the 2011 proxy season in the wake of public concern about the role of excessive remuneration in the global financial crisis.
Executives aren’t happy.
James Packer’s Crown saw a 50per cent vote against the executive remuneration package, and lashed out to shareholders saying “If we receive a second strike again next year we will be left in the farcical position of the board being subject to a spill. If that happens I will use my votes to ensure all directors are voted back in immediately”.
In time companies will become more adept at properly explaining their remuneration structures to shareholders which will dampen the current enthusiasm for protest votes. However I hope that shareholders maintain vigilance.
On that note, it is of critical importance to this whole debate understand what sorts of remuneration structures best incentivise decision making for the long term prosperity of the company, and consequently, the shareholders.
Leading behavioural economist Dan Ariely has conducted numerous experiments on the impact of bonus structures on work performance under controlled conditions, which appears particularly relevant. Here is a glimpse at some of his findings:
What would you expect the results to be? When we posed this question to a group of business students, they said they expected performance to improve with the amount of the reward. But this was not what we found. The people offered medium bonuses performed no better, or worse, than those offered low bonuses. But what was most interesting was that the group offered the biggest bonus did worse than the other two groups across all the tasks.
More detailed discussion of other results can be found at Dan’s blog. Similar counterintuitive findings (to the trained economist at least) are emerging from the area of fund management and financial advisory, especially in work by Nobel Prize winner Daniel Kahneman:
For example, he studied the results achieved by 25 wealth advisers, across eight years. He found that the consistency of their performance was zero. “The results resembled what you would expect from a dice-rolling contest, not a game of skill.” Those who received the biggest bonuses had simply got lucky.
Such results have been widely replicated. They show that traders and fund managers across Wall Street receive their massive remuneration for doing no better than would a chimpanzee flipping a coin. When Kahneman tried to point this out they blanked him. “The illusion of skill … is deeply ingrained in their culture.”
So much for the financial sector and its super-educated analysts. As for other kinds of business, you tell me. Is your boss possessed of judgement, vision and management skills superior to those of anyone else in the firm, or did he or she get there through bluff, bullshit and bullying? (here)
It is of utmost importance, therefore, that the sometimes perverse outcomes of performance bonuses, and the role of luck, be considered when exercising this new-found shareholder control.
Globally the corporate world appears to be slowly heading towards a new era of accountability, and Australia is keeping pace with these developments. I hope that this provides opportunities to better understand the motivational and decision making impacts of bonus payments, and be able to isolate and reward the tough decision that prove beneficial for the company, from the luck that comes from being in charge at the right time in the economic cycle.